How to prepare for MiFID II: an automated solution is the best approach

James Brown is Senior Energy Consultant at Allegro Development EMEA
James Brown, Senior Energy Consultant at Allegro Development EMEA

If it isn't regional conflict or extreme weather injecting risk into the energy value chain, politics and its regulatory offspring seem to constantly evolve new rules and penalties that create uncertainty.

Even as energy derivatives markets get to grips with 2014's EMIR and REMIT compliance deadlines, a new set of MiFID rules is reaching beyond banking to take in commodity trading as well, with far reaching implications that require a technological response.

EU regulators responded to the financial crisis by creating the Markets in Financial Instruments Directive (MiFID) to increase competition and consumer protection in financial services, and a bifurcated regime (EMIR and REMIT) to address potential manipulation in commodity trading.

These last two are rolling out now but even as they complete their implementation phase, MiFID II threatens to add to the compliance burden for commodity traders, whilst making it harder for businesses to operate under a hedging strategy.

MiFID II consists of a directive which must be implemented by each EU Member State and a regulation which is applied across the EU. As with EMIR and REMIT, technical standards and other secondary legislation will need to be drafted, agreed and adopted by ESMA before the new legislation is implemented.

I would advise to prepare for final MiFID II readiness by early 2017, and here is what to watch for over the next 18 months:

  • Clarity over how a market participant's positions will be aggregated and netted
  • Whether or not physical forwards will be treated as OTC derivatives
  • An exact definition of hedging, which will be extremely important for companies hoping to make use of the 'hedging exemption'

Hedging and risk management strategies will have to be revised and adapted as the final form of MiFID II becomes incrementally clearer. Although it is too soon to make major changes, there are things you can do now to mitigate exposure to regulatory risk.

Mitigating risk

The right technology investments can help mitigate regulatory risk by surfacing exposures and providing quick assurance that trades and related activities are compliant. This has already been shown through EMIR and REMIT, which compelled many companies to invest in or revisit their Commodity Trading and Risk Management (CTRM) systems. MiFID II could well necessitate another round of IT upgrades, particularly in the area of reporting to trade repositories.

While it is still too soon to make firm or detailed ETRM recommendations, starting the due diligence process with trusted vendors should begin now.

A regulatory IT solution for commodity trading and corporate financial compliance is generally not a standalone application. Contract data, hedge accounting, revenue allocation in line with new regulatory reporting requirements and other special functions do not happen in a vacuum. Direct connectivity to trade repositories must also be a core capability.

When the first EMIR trade reporting deadline landed in February last year, the market still wasn't ready. After months of delay and rethink by EU regulators during EMIR's rollout, a host of companies found themselves playing catch up, hurriedly (and expensively) trying to understand how to meet the new regime's data requirements and definitions.

We need to learn from that experience, and begin preparing for MiFID II readiness now. With so many evolving dimensions, however, implementing systems that can accommodate an evolving rollout will be absolutely essential to success.

What energy market IT leaders can do to prepare

Despite ambiguities around the rollout there are alternatives in terms of what energy and fanatical services CIOs can do now to prepare for MiFID II. Managing the process by spreadsheet is not one of them. There are electronic reporting and data storage requirements involved in each set of regulations that will quickly overwhelm manual processes.

Outsourcing may be a solution, but it comes with its own costs and risks. There is the added overhead of an ongoing contract to manage, so how active you are in the energy trading arena will determine your breakpoints financially.

But in the end, do you really want to outsource a liability you will ultimately be held accountable for should any errors or delays in compliance occur? A third-party provider will most likely not be responsible for paying fines. Even if you could negotiate a contract that held them financially liable, what would an infraction mean to your brand reputation? The collateral cost of cleaning up a public relations nightmare could be devastating.

That leaves accepting higher energy prices by abandoning a hedging strategy altogether, or automating the process. After weighing the options, automation is the best business decision.

ETRM system

Automating regulatory processes requires a basic energy trading and risk management (ETRM) system, which is a comprehensive regulatory solution for commodity trading and corporate financial compliance. ETRM is generally not a standalone application and needs to incorporate contract data, hedge accounting, revenue allocation, and all the import regulatory reporting requirements for your geographic markets.

In light of the evolving standards for EMIR and REMIT, you will want to choose a solution that allows you to upgrade and manage your regulatory compliance process quickly. Another qualifier to consider is the ability to install software on a captive system and maintain it internally, or purchase a software-as-a-service (SaaS) contract and maintain it virtually in the cloud. Implementing this option could affect your overall total cost of ownership as you integrate the system into other areas of the business.

Direct connectivity to trade repositories should also be a core capability, including all required regulatory identifiers and formats. The system should be able to simplify the threshold monitoring for non-financial counterparties (e.g. energy intensive businesses operating a hedging strategy) and facilitate risk mitigation obligations, including EMIR's requirement for periodic portfolio reconciliations.

Energy traders need to address MiFID II compliance today and, given the evolving standards and timelines that define today's regulatory environment, an automated solution offers the best and fastest approach to meeting the requirements.